TO:	Honorable Dan Flynn, Chair, House Committee on Pensions
FROM:	Ursula Parks, Director, Legislative Budget Board
IN RE:	SB2190 by Huffman (Relating to the public retirement systems of certain municipalities.), As Engrossed

The following information was supplied by Agency 338 - Pension Review Board:

SB 2190, as engrossed, would make significant changes to Articles 6243e.2(1) (affecting the Houston Firefighters' Relief & Retirement Fund (HFRRF)), 6243g-4 (affecting the Houston Police Officer's Retirement System (HPOPS)), and 6243h (affecting the Houston Municipal Employees Retirement System (HMEPS)), Revised Civil Statues, to immediately reduce benefits, increase employee contributions, outline funding policies, codify certain actuarial assumptions and methods for purposes of valuing benefits, and detail an approach to making modifications to the assumptions, methods and benefits under certain economic scenarios with the intent of minimizing the volatility of future contribution requirements for the affected retirement systems. Currently, the City of Houston's (the "City") contribution structure for HFRRF is outlined in its governing statute, and for HMEPS and HPOPS the contributions are established through the most recent meet and confer agreements with the City.

 

The proposed changes of the bill, if enacted, would help strengthen the long-term sustainability and improve the actuarial soundness of the affected retirement systems by lowering the current and future liabilities.

 

Background on Actuarial Analyses

The actuarial analysis provided by HFRRF relies on assumptions, methods, and plan provisions outlined in the draft July 1, 2016 valuation report. To remain consistent with previous reviews of this bill and in accordance with Texas Government Code Section 802.302(h), the PRB is also including the actuarial analysis prepared by Retirement Horizons Incorporated (RHI) at the direction of the City.

ACTUARIAL EFFECTS

PRB's actuarial review states that the affected retirement systems are currently identified as being actuarially sound under the PRB Guidelines for Actuarial Soundness. However, the City has stated that its pension liabilities for the three retirement systems have risen to $8.1 billion and it is facing the prospect of increasing costs that have the potential to outpace its ability to pay. The proposed changes help strengthen the long-term sustainability and improve the actuarial soundness of the affected retirement systems. In addition, because the bill requires an automatic adjustment of the required contributions for HPOPS and HMEPS should the systems not receive the planned POB proceeds; the bill would still serve to improve the actuarial soundness of these two systems.

Further, while the bill requires voter approval for the issuance of POBs, the HPOPS and HMEPS actuarial analyses do not address the impact on future costs if the proceeds of the POBs are not received. However, if the POBs are not issued, the bill would allow HFRRF, HPOPS and HMEPS to rescind, prospectively, any or all benefit changes made effective under the bill, or allow HPOPS and HMEPS to reestablish the deadline of the delivery of the POB proceeds, if the city fails to deliver the proceeds of the pension obligation bonds before March 31, 2018.

Accordingly, if any or all benefit changes are rescinded for HPOPS, the corridor minimum, maximum, and mid-point contributions would increase. The PRB does not have sufficient data to determine the magnitude of the impact. For HMEPS, based on the actuarial analysis each payment in the Legacy Liability amortization schedule would increase by approximately 10% and the corridor minimum, maximum, and mid-point contributions would increase approximately 1.4%.

Baseline and If Bill Enacted Scenarios

The following tables provide the key financial impact on HFRRF, HPOPS and HMEPS as provided in the actuarial analyses. The Baseline scenario utilizes assumptions, methods, and plan provisions described in the latest valuation reports from the systems (July 1, 2015 valuation reports for HFRRF, prepared by RHI for the City, and HMEPS and July 1, 2016 valuation report for HPOPS), with modifications, including a lowered 7.0% discount rate; the change from an open to a closed 30-year amortization period; and marking the assets to market.

 

Also, the Baseline scenario for HFRRF (prepared by Conduent) utilizes the assumptions, methods, and plan provisions described in a draft copy of the July 1, 2016 Valuation Report. The assumptions, methods, and plan provisions are substantially the same as the July 1, 2015 Valuation report but utilize a  7.00% assumed rate of return, an updated mortality table and calculates the City contribution based on a 30-year closed amortization period beginning July 1, 2015 (i.e. a 29-year amortization period as of July 1, 2016). Additionally, the Baseline scenario utilizes the smoothed value of assets as of July 1, 2016 and the If Bill Enacted scenario uses the market value of assets, as required by the bill. The If Bill Enacted scenario also makes changes to assumptions, methods, and benefits based on the provisions of the bill as well as expected changes in participant behavior. Please note, for HFRRF, the definition of payroll would be changed under the bill to exclude overtime.

 

The If Bill Enacted scenario shows the effect of the additional changes to assumptions, methods, increased employee contributions, and the decreased benefit provisions as contained in the bill.

 

The following tables outline the previously mentioned scenarios.

 

*The provision for administrative expenses expressed here exceeds the maximum allowable under the bill, which is 1.25%.

**The amortization payment for the Baseline scenario has been calculated using a 30-year amortization period in accordance with the City's interpretation of Section 13(d), Article 6243e.2(1), Title 109 Revised Civil Statutes, which means that the retirement system's UAAL will never be completely paid off. 

***The definition of payroll would be changed under the bill to exclude overtime. The City contribution has been calculated as a percentage of pensionable pay, excluding overtime for both the Baseline and If Bill Enacted scenarios.

****For comparison purposes, the total employer contribution has also been calculated as a percentage of gross pay (including overtime).

 

 

*Smoothed value of assets for the Baseline scenario and market value of assets for the If Bill Enacted scenario.

**The actuarial analysis does not indicate if there is an explicit assumption for administrative expenses under the Baseline scenario.

***The amortization payment for the Baseline scenario has been calculated using a 29-year amortization period as of July 1, 2016. The HFRRF Board of Trustees voted October 18, 2016 to interpret Section 13(d), Article 6243e.2(1), Title 109 Revised Civil Statutes to require a finite 30-year amortization period,  effective July 1, 2015, rather than an open 30-year amortization period. The PRB is not aware of any reason to change the existing interpretation of the statute at this time.

****The total employer contribution has been calculated as a percentage of gross pay (including overtime).

 

 

Both scenarios include the discounted value of expected POB proceeds ($750 million).

 

If Bill Enacted scenario includes the discounted value of expected POB proceeds ($250 million).

Corridor Midpoint

The bill establishes a unique funding policy that establishes a "target" contribution rate for the City, develops a minimum and maximum corridor around the City's target contribution rate, and defines steps that must be taken should the annual calculated contribution move outside this corridor. Generally, for all three retirement systems, the retirement system and the city must jointly determine the expected contribution requirements for the 31-year period beginning with the fiscal year starting July 1, 2017, consisting of the expected normal cost plus a closed 30-year amortization of the unfunded liability as it exists on June 30, 2016. For HFRRF and HPOPS, the sum of the expected normal cost, amortization payment and a provision for administrative expenses for each of the next 31 years becomes the "target" rate or corridor mid-point. For HMEPS, the corridor mid-point is the sum of the normal cost and provision for administrative expenses. The minimum and maximum contribution "corridor" then becomes the rates equal to /-5% of the projected mid-point.

 

The 30-year amortization schedule of the unfunded liability as of June 30, 2016, known as the legacy liability, is established and treated separately from the corridor for HMEPS, therefore, generally any reference in this statement to outstanding amortization payments, as it relates to HMEPS, does not include the amortization of the legacy liability. Without regard to the legacy liability for HMEPS, the corridor mechanisms for all three systems are similar.

 

Additionally, in future years, a new base would be established to amortize gains and losses. The losses are amortized over a closed 30-year period, while the gains are amortized over the same period as the largest outstanding liability loss base, the gain and associated loss base are treated as a single base for any future actions.

 

Once the corridor is established in the initial valuation, it will not change. The following tables outline the estimated 31-year projections of the corridor mid-point for the three systems (and legacy liability amortization schedule for HMEPS) as provided in the actuarial analyses. While the actuarial analysis prepared by Conduent included an estimate of the immediate impact on the FYE 2018 cost, it did not include a projection of annual costs after FY 2018.

 

 

 

 

 

 

Actuarial Assumptions and Methods

PRB actuarial review notes that the non-prescribed assumptions and methods used in the analyses from HMEPS, HPOPS and the City for HFRRF are reasonable.

 

The actuarial review also notes that the HFRRF analysis prepared by Conduent relies on assumptions and methods outlined in the draft July 1, 2016 actuarial valuation report. The PRB has not had an opportunity to completely review the assumptions and methods underlying the actuarial analysis and is therefore unable to speak to their reasonableness.

Additionally, the bill mandates the use of the Ultimate Entry Age Normal (UEAN) cost method and a 7.00% assumed rate of investment return, rather than what the systems used in the most recently published actuarial valuations.

The Entry Age Normal (EAN) level percent of payroll cost method is a mathematical construct designed to spread the costs of a participant's total benefit as a level amount over their entire career. This is done by calculating an annual amount that will remain relatively constant when expressed as a percentage of pay, and be sufficient to fully fund the anticipated benefits when the participant separates service. This results in a relatively stable normal cost contribution requirement from year to year.

 

The PRB actuarial review further states that the UEAN cost method is a variation of the Entry Age Normal (EAN) cost method. The UEAN cost method calculates the total anticipated benefits, or Present Value of Future Benefits (PVFB), based on a member's actual benefit provisions, but calculates the future accruals or Present Value of Future Normal Costs (PVFFNC) using the benefit provisions for new hires. The Actuarial Accrued Liability (AAL) is the difference between the PVFB and PVFNC. The purpose of this approach is to produce a stable normal cost calculation over the anticipated careers of the entire population, not just over the individual participant's career. When comparing results between these two variations, the UEAN cost method will result in a higher AAL than EAN. However, this is offset by lower expected future normal costs. Both cost methods converge to the same values at the time the participant is expected to separate service.

 

The following tables show the changes to assumptions and methods for each system.

 

 

 

 

 

 

SYNOPSIS OF PROVISIONS

SB 2190, as engrossed, would amend and add sections to Title 109, Revised Civil Statutes Articles 6243e.2(1), 6243g-4, and 6243h to reduce benefits (summarized in tables below), increase employee contributions (summarized in tables below), outline funding policies, codify certain actuarial assumptions and methods for purposes of valuing benefits, and detail an approach to making modifications to the assumptions, methods and benefits under certain economic scenarios with the intent of minimizing the volatility of future contributions requirements for the affected retirement systems. The bill would also require the city to make contributions as outlined by the risk sharing sections.

 

Risk Sharing Corridor

The bill would set baseline assumptions in statute to implement the risk sharing corridor. The corridor sets a minimum and maximum city contribution rate. In a falling-cost environment, gains are used to accelerate the payoff of unfunded liabilities or reduce the interest rate. In a rising-cost environment, adjustments are made to the amortization period, employee contributions, or benefits to reduce the city contribution rate.

 

Additional Reporting Requirements

The bill would add reporting requirements for the three systems, including the requirement to conduct actuarial experience studies at least once every four years with the first experience study for HFRRF no later than September 30, 2020 and for HPOPS no later than September 30, 2022 and for HMEPS published no later than September 30, 2021. The systems must also contract with an investment consultant to perform an audit on investments at least once every three years.

PRB Review of Risk Sharing Valuation Study (RSVS)

The bill would require the systems and City to jointly submit a copy of the RSVS to the PRB for a determination that the pension systems and city are in compliance with the articles. The PRB shall notify the governor, lieutenant governor, the speaker of the house of representatives, and the legislative committees having principal jurisdiction over legislation governing public retirement systems if the PRB determines the system or city is not in compliance with the applicable sections.

 

City Approval of POBs

The bill would amend Chapter 107, Local Government Code to require voter approval for POBs issued to fund the Houston pension systems.

 

Delivery of POBs

The bill would allow HFRRF, HPOPS and HMEPS to rescind, prospectively, any or all benefit changes made effective under the bill, or and allow HPOPS and HMEPS to reestablish the deadline of the delivery of the POB proceeds, if the city fails to deliver the proceeds of pension obligation bonds before March 31, 2018. If HPOPS and HMEPS do not receive the proceeds from the POBs by December 31, 2017, the initial RSVS shall be re-prepared without assuming delivery of POB proceeds.

 

Alternative Retirement Plans

The bill would allow the three retirement systems' boards and the City to enter into a written agreement to offer an alternative retirement plan or plans, including a cash balance retirement plan, if both parties consider it appropriate.

 

The bill would also require the respective boards to close the existing plan to new entrants and establish a separate cash balance plan for new hires under the following circumstances:

1)      For HFRRF and HPOPS, if the plan's ratio of assets to liabilities falls below 65% at any time after June 30, 2021, and

2)      For HMEPS, if the plan's ratio of assets to liabilities falls below 60% at any time after June 30, 2027.

 

The requirement to establish a separate cash balance plan for new hires will not take effect for HMEPS if they do not receive the required POB proceeds. The requirement to establish a separate cash balance plan for new hires will not take effect for HFRRF or HPOPS if HPOPS does not receive the required POB proceeds.

Effective Date

Except as otherwise provided by the Act, the Act takes effect July 1, 2017 if it receives a vote of two-thirds of all the members elected to each house, or September 1, 2017.

 

 

 

 

FINDINGS AND CONCLUSIONS

Given that the bill provisions for the three retirement systems would strengthen the funding policy and reduce current liabilities, it increases the long-term funding security for all members of the affected retirement systems. It impacts all current and future active members because it increases the employee contributions for all three affected systems. In addition, certain classes of active and inactive members are impacted by changes in plan provisions.

 

The actuarial review states that each of the affected retirement systems use different actuarial methods and assumptions to determine the annual required contribution. The bill mandates the use of the Ultimate Entry Age Normal cost method and a 7.00% assumed rate of investment return for purposes of determining the annual required contributions. The baseline scenarios in all 4 analyses use an assumed rate of return on assets of 7.00%. The baseline scenario of both HFRRF analyses and the HPOPS analysis use the Individual Entry Age Normal cost method, while HMEPS uses the Ultimate Entry Age Normal cost method.

 

The bill also requires the starting Actuarial Value of Assets be marked-to-market and recognize the discounted value of the proceeds for the anticipated POBs. The baseline scenario for HFRRF prepared by Conduent uses the smoothed value of assets, while the other 3 analyses use the market value of assets. In addition the analysis for HPOPS includes the discounted value of the POBs in the baseline scenario, while the HMEPS analysis does not. No POB proceeds are anticipated for HFRRF.

 

There are additional considerations to note for both HFRRF actuarial analyses:

 

The HFRRF analysis prepared by RHI  relies on grouped census data for retirees, disabled members, beneficiaries, and members with deferred benefits, as well as aggregate DROP balances for inactive members as of from the July 1, 2015, provided by the HFRRF actuary. RHI also did not receive a formal actuarial communication from the HFRRF actuary to confirm the plan provisions or actuarial assumptions and methods being used. Given these issues, the actual costs and savings could be materially different from the results provided in the actuarial analysis provided by the City.

 

The HFRRF analysis prepared by Conduent relies on assumptions, methods, and plan provisions outlined in the draft July 1, 2016 actuarial valuation report. The PRB has not had an opportunity to completely review the assumptions and methods underlying the actuarial analysis, we are therefore unable to speak to the reasonableness of the calculations.

 

The HFRRF analysis prepared by Conduent under the If Bill Enacted scenario shows a total contribution requirement of 33.60% vs 25.82% for the RHI analysis. The majority of this difference is driven by the difference in AAL and the resulting amortization of the UAAL. The PRB has noted some areas of concern with both analysis (RHI relies on grouped census data) but did not have sufficient time to discuss these areas of concern or the cause of the differences in calculations with the respective actuaries. Therefore, the PRB have been unable to reconcile the differences for this review.

 

Based on the benefit provisions as provided in the analyses from HMEPS, HPOPS and the City for HFRRF, the establishment of the Baseline scenarios, and assuming the issues raised specifically with the HFRRF analysis prepared by RHI would not result in a material difference in results, the actuarial analyses prepared by GRS and RHI provide a reasonable estimate of the changes due to the bill.

 

Additionally, the actuarial review notes that the bill would require each of the systems to close the existing plan to new entrants and establish a separate cash balance plan for new hires if the funded ratio falls below a specified level in the future. The analysis for HMEPS indicates there is a 55—60% probability that they will fall below the threshold at some point after 2027 and therefore there is a higher probability of the trigger occurring than not occurring. Should this occur, the analysis indicates the estimated impact would be an increase in the discounted value of employer contributions ranging from $72 million to $222 million. The analysis further notes that if the bill language is clarified to indicate that a completely separate plan is not required, but instead the funds are comingled for cash flow purposes, the original analysis is not impacted. The PRB has not had an opportunity to review the assumptions and methods for developing the probability or the range so cannot speak to the reasonableness of this specific projection. The other analyses did not include an estimate of the respective systems falling below the stated thresholds.

 

GASB EFFECTS

All three actuarial analyses from HMEPS, HPOPS and the City for HFRRF include data showing impact on accounting information. The passage of SB 2190, as engrossed, with the assumption and benefit changes (lower discount rate, strengthened funding policy, employee contribution increases, and benefit reductions) is likely to have a positive impact on the retirement systems and the City under the Governmental Accounting Standards Board (GASB) reporting standards (GASB 67 & 68).   

 

 

 

METHODOLOGY AND STANDARDS

 

According to the PRB actuaries, to the best of their knowledge, no material biases exist with respect to the data, methods or assumptions used to develop the analyses other than those specifically identified above and in the actuarial review. The PRB did not audit the information provided but has reviewed the information for reasonableness and consistency with other information provided by or for the affected retirement systems. The PRB is not responsible for the accuracy or completeness of the information provided to the agency. All actuarial projections have a degree of uncertainty because they are based on the probability of occurrence of future contingent events. Accordingly, actual results will be different from the results contained in the analysis to the extent actual future experience varies from the experience implied by the assumptions. This analysis is based on the assumption that no other legislative changes affecting the funding or benefits of HFRRF, HPOPS, or HMEPS will be adopted. It should be noted that when several proposals are adopted, the effect of each may be compounded, resulting in a cost that is greater (or less) than the sum of each proposal considered independently.

 

SOURCES

City of Houston Cost Analysis for HFRRF by David A Sawyer, FSA, EA, MAAA; and Carly A. Nichols, FSA, EA, MAAA, Retirement Horizons Incorporated, March 15, 2017.

HFRRF Actuarial Analysis by David L. Driscoll, FSA, EA, MAAA, FCA, Conduent Business Services, LLC, May 2, 2017

HPOPS Actuarial Analysis by Mark R. Randall, FCA, MAAA, EA; and Joseph P. Newton, FSA, EA, MAAA, Gabriel Roeder Smith & Company, March 7, 2017.

HMEPS Actuarial Analysis by Lewis Ward; and Joseph P. Newton, FSA, EA, MAAA, Gabriel Roeder Smith & Company, May 3, 2017.

Actuarial Review by Kenneth J. Herbold, ASA, EA, MAAA, Staff Actuary, Pension Review Board, May 3, 2017.

 

GLOSSARY

Actuarial Accrued Liability (AAL) -The portion of the PVFB that is attributed to past service.

Actuarial Value of Assets (AVA) - The smoothed value of system's assets.

Amortization Payments - The yearly payments made to reduce the Unfunded Actuarial Accrued Liability (UAAL).

Amortization Period - The number of years required to pay off the unfunded actuarial accrued liability. The State Pension Review Board recommends that funding should be adequate to amortize the UAAL over a period which should not exceed 40 years, with 15-25 years being a more preferable target. An amortization period of 0-15 years is also a more preferable target.  

Actuarial Cost Method - A method used by actuaries to divide the Present Value of Future Benefits (PVFB) into the Actuarial Accrued Liability (AAL), the Present Value of Future Normal Costs (PVFNC), and the Normal Cost (NC).

Funded Ratio (FR) - The ratio of actuarial assets to the actuarial accrued liabilities.

Net Pension Liability (NPL) - The liability of employers and non-employer contributing entities for pension benefits shown on the entity's balance sheet for FYE 6/30/2015 and later. The NPL equals the TPL minus the market value of plan assets. (If plan assets exceed the TPL, there is a Net Pension Asset.)

Total Pension Liability (TPL) - The portion of the actuarial present value of projected benefit payments attributed to past periods of employee service under the Entry Age Normal valuation method.

Discount Rate - A single rate used to discount and calculate the TPL which is equivalent to discounting future payments reflected in the TPL at the long-term expected rate of return until plan assets are projected to be exhausted, and discounting at the municipal bond rate for subsequent payments reflected in the TPL.

Market Value of Assets (MVA) - The fair market value of the system's assets.

Normal Cost (NC) - The portion of the PVFB that is attributed to the current year of service.

Present Value of Future Benefits (PVFB) - The present value of all benefits expected to be paid from the plan to current plan participants.

Present Value of Future Normal Costs (PVFNC) - The portion of the PVFB that will be attributed to future years of service.

Unfunded Actuarial Accrued Liability (UAAL) - The Actuarial Accrued Liability (AAL) less the Actuarial Value of Assets (AVA).